Despite the uncertainty still surrounding Brexit, finance departments will need to prepare. Regardless of the ultimate outcome, it is likely to cause currency market volatility — especially with the British pound (GBP) — and that will significantly impact European companies that do business in the UK.
To find out how those companies might hedge against foreign exchange upsets, FM magazine spoke to Christophe Boizard, the CFO of the Belgian multinational insurance company Ageas, and Christian Debus, a partner in Finance and Treasury Management at KPMG Germany. Here is what they said.
What will you do if the pound drops, or rallies, significantly?
Boizard: We will not act on such market movements.
After this maybe surprising and short answer to your question, let me elaborate on how Ageas manages its foreign currency exposures. Let me share some of the key highlights of our currency policy:
Each business must eliminate the currency risk by investing into assets or hedging the currency exposure through derivatives which matches our local liabilities or commitments vis-à-vis our clients. That is what we call the “currency matching”, and there is no waiver within the Group [Ageas and its subsidiaries] on this prescription. In Ageas UK for example, where we only have GBP-denominated liabilities, we primarily invest in GBP-denominated assets.
At Group level, we are in a different situation, and Ageas SA/NV, the top holding of the Group, is exposed to currency volatility in several areas:
- In the balance sheet with our stakes in the non-euro subsidiaries or affiliated companies. The accounting impacts are directly recognised in shareholder equity. So the change in valuation in euro doesn’t have profit and loss accounting implications, and our currency policy does not require an equity hedge.
- In the P&L through the conversion to euros of the net results coming from subsidiaries outside the euro zone. The UK is, of course, one of them. The short-term volatility is filtered through the exchange rate, which under IFRS rules is the average of the period. When the referendum result in the UK was announced, the GBP experienced a sharp fall, but barely visible in the Q2 results as a result of the averaging effect of the applied fx over the first six months. On the following Q3 closing, despite the sharp drop of the GBP, we continued to benefit from the relatively stable fx over the first three months. Our policy is to not to hedge the currency risk associated with profits and loss of local subsidiaries.
- On the treasury, dividends, and M&A transactions, we have a different view. There we also have a currency risk which in some specific cases related to the certainty of the amounts transferred and dates of realisation, hedges can be contemplated (either options but more often forwards or even contingent forwards).
In theory, the currency volatility at Group level could be hedged but with significant operational hassles: The holding would indeed be exposed to regular (weekly at least) margin calls corresponding to the market value adjustments of the hedges in place. Amounts could be very significant in a structure with no operational cash flows and limited cash flexibility. The volatility of the margin calls could put the liquidity of the holding at risk.
On a broader perspective more related to its strategy, Ageas is a long-term investor and a long-term insurer in the “home” markets where it has chosen. The UK is one of the three home markets we have, and our intention is to stay. I personally think that whatever the final Brexit solution will be — hard, less hard, or soft — the UK will remain one of the main economies of the world and hence an attractive insurance market, and we are not really concerned on the short-term bumpy road ahead of us.
How does this align with or impact your risk management strategy?
Boizard: Our risk management strategy drives our definition of “risk appetite” with the main focus on the maximum possible loss we are ready to accept on the Group consolidated result. Since, as I already explained, the currency movements do not translate directly into P&L impacts, we by definition stay within the defined limits, and our risks management strategy doesn’t put real constraints on the way currencies are managed.
On the balance sheet side, the currency translation reserve, which books all the currency volatility, benefits from the geographical diversification of our operations. We operate indeed in China, Thailand, Malaysia, and India, where the currencies are not correlated to the GBP. At the end the GBP weakness observed after the referendum, while being cumbersome, didn’t hit by more than 2% to 3% of the shareholder equity. That is perfectly acceptable and well understood by the financial analysts.
What effect will this have on your strategic planning and goals moving forward (in terms of shifting markets or developing new business strategies, for example)?
Boizard: We want our local teams to be 100% accountable for their business performances, and honestly it wouldn’t be fair to compensate or penalise a team with a currency component in the assessment of their achievements!
So targets are set in local currencies, and the Group absorbs the currency volatility without hedging it.
So to answer precisely to your question, there is no effect on the strategic planning.
How, specifically, is your finance department hedging for continued fluctuations? Are you using forward contracts? Options?
Boizard: As explained above, no specific actions are taken for hedging the continued fluctuations of IFRS equity and P&L contribution from the subsidiaries operating outside the euro zone.
We do hedge the M&A transactions in foreign currencies, and in our recent investments in India, the amount was hedged with a contingent forward contract as soon as the binding offer was signed to freeze the financial terms of the business plan presented to the board.
We tend to avoid options which are expensive and carry upfront premium. Contingent forward in certain circumstances offers a better alternative, even though such instruments tend to require more operational work.
What should other European insurers, retailers, real estate companies, or other businesses that operate in the UK consider as they prepare for foreign exchange market upsets going forward?
Boizard: As much of our currency policy suits our specific needs and reflects our core principles, I believe it is not a reflection of how currency risk is managed by the wider insurance sector. I also believe that other industries and our peers in the insurance sector could have a very different stance and may implement more active hedging strategies.
In case of M&As or realisation of returns on volatile or short-term investments, currency protections should be put in place so that currency issues cannot derail the profitability and the associated business plan.
The UK Brexit referendum in 2016 sparked the largest one-day drop in the pound. Are you anticipating something as dramatic as that on the date that Brexit officially occurs?
Boizard: Usually markets outline different scenarios from the best to the worst but tend to price more on the “worse” side, and thus I do not anticipate any dramatic moves in the near future irrespective of the outcome, but I can be wrong!
Will there be lasting damage to the euro? How can your department prepare for that?
Boizard: I frankly cannot see any reasons for a long-term damage for the euro. The euro can be under pressure but more due to well-known internal problems within the euro zone, which are not new to the financial markets.
As a conclusion, I would say that you have in front of you a rather relaxed CFO, at least on the currency side!
It remains to be seen what Brexit will ultimately look like, but the currency markets are likely to fluctuate in any scenario. If the British pound continues to slide, it will affect European companies that do business in the UK and convert pounds to euros. What should those companies, such as insurers, retailers, and real estate businesses, do if the pound drops significantly — or if it rallies? What should they be considering now as they prepare for foreign exchange market upsets going forward?
Debus: Corporate treasurers are used to dealing with currency fluctuations following political decisions, and many will think back to the lessons learned after the 2016 Brexit referendum. In these circumstances treasurers should hedge their exposure to a degree that would not lead to significant impacts in the case of an adverse result. This requires an assessment of the risk horizon that considers how quickly prices can be adapted to new exchange rates. The threat of a no-deal Brexit is already partially taken into account by today’s fx rates, so the magnitude of any potential impact needs to be seen in that light.
Specifically, how should they hedge?
Debus: Most corporates will use forwards as they do not require the payment of a premium. Options are a good means to protect against the downside; however, given the higher volatility, their cost could be significant. One strategy might be to determine the worst exchange rate your company is willing to accept and then set the strike price accordingly.
What are you hearing from European companies about their risk management strategies? What sort of impact might this have on them?
Debus: The appearance of black swan events in the currency markets has made treasurers much more aware of the necessity of an advanced fx risk management approach. Instead of using deterministic strategies, people are switching to more sophisticated [key performance indicators], like VaR [value at risk], to determine the level of their hedges. These metrics include volatility as an indicator and make hedges dependent on their impact on earnings.
How could currency fluctuations affect their strategic planning and goals? Are companies likely to shift markets or develop new business strategies?
Debus: Currently the main concern in Europe is whether firms will be able to do business in the UK. Some are looking to relocate manufacturing to ensure the steady supply of materials or sales to customers. For corporate treasurers the biggest question seems to be whether their financial transactions with UK-based banks — especially derivatives transactions — will remain subject to the current legislation. Some corporates are beginning to shift their derivatives from UK banks to banks in the EU.
Might there also be damage to the euro? How can European finance departments prepare for that?
Debus: Brexit is expected to impact both the UK economy and those of EU countries. Financial markets may also come to see a greater economic risk in the euro zone. Corporate treasurers are used to increased volatility in currency markets due to political decisions. Most realise that closer monitoring of the currency markets and a more flexible and sophisticated hedging strategy, with a wider use of instruments, is needed.
— Portia Crowe is a freelance writer based in the UK. To comment on this article or to suggest an idea for another article, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.